Farm Management
Chapter 9
Cost Concepts in Economics
Chapter Outline
•
•
•
•
Opportunity Cost
Costs
Application of Cost Concepts
Economies of Size
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Chapter Objectives
1.
2.
3.
4.
5.
6.
7.
To explain the importance of opportunity cost and
its use
To clarify the difference between short run and
long run
To discuss the difference between fixed and
variable costs
To identify fixed costs and show how to compute
them
To show how to compute average costs
To demonstrate the use of costs in short run and
long run decisions
To explore economies of size
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Opportunity Cost
• The value of a product not produced
because an input was used for another
purpose, or
• The income that could have been
received if the input had been used in
its most profitable alternative use
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Everything Has an Opportunity Cost
Even if you use the input in its best
possible use, there is an opportunity
cost for the item you did not produce.
(In this case, opportunity cost will be
less than the revenue actually received.)
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Table 9-1
Opportunity Cost of Applying Irrigation Water
Among Three Uses
Marginal Value Products ($)
irrigation water
wheat
sorghum
(acre inches)
(100 acres)
(100 acres)
4
$1,200
$1,600
8
$800
$1,200
12
$600
$800
16
$300
$500
20
$50
$200
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cotton
(100 acres
$1,800
$1,500
$1,200
$800
$400
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How Does Opportunity Cost Relate
to the Equi-Marginal Principle?
With the Equi-Marginal Principle,
we are choosing to produce one
product instead of another. The
opportunity cost is the revenue
given up from the crop not
produced.
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Opportunity Cost of Operator Time
• Opportunity cost of operator's labor:
What the operator could earn for that
labor in best alternative use
• Opportunity cost of operator's
management: Difficult to estimate
• Total of opportunity cost of labor and
opportunity cost of management
should not exceed total expected salary
in best alternative job
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Opportunity Cost of Capital
The opportunity cost of capital is often set
equal to what the capital could earn in a
no-risk savings account.
Total dollar value of the capital inputs is
estimated and multiplied by the interest
rate for a savings account.
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Costs
•
•
•
•
•
•
•
Total Fixed Cost (TFC)
Average Fixed Cost (AFC)
Total Variable Cost (TVC)
Average Variable Cost (AVC)
Total Cost (TC)
Average Total Cost (ATC)
Marginal Cost (MC)
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Cost Concepts
These seven costs are output related.
Marginal cost is the cost of producing an
additional unit of output. The others are
either the total or average costs for
producing a given amount of output.
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Short Run and Long Run
The short run is the period of time during
which the quantity of one or more
production inputs is fixed and cannot
be changed.
The long run is the period of time in which
the amount of all inputs can be changed.
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Fixed Costs
• Fixed costs exist only in the short run.
•. In the short run, fixed costs must be
paid regardless of the amount of output
produced.
• Fixed costs are not under the control of
the manager in the short run.
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Depreciation is a Fixed Cost
Annual depreciation using the
straight-line method is:
Original Cost — Salvage Value
Useful Life
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Interest is a Fixed Cost
Cost + Salvage Value
Interest =
2
r
r = the interest rate
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Other Fixed Costs
Property taxes and insurance are also
fixed costs.
Some repairs may be fixed costs, if
they are for maintenance. In practice,
machinery repairs are usually counted
as variable costs, while building repairs
are counted as fixed.
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Computing Total Costs
• Total Fixed Cost (TFC): The sum of all
fixed costs
• Total Variable Cost (TVC): The sum of
all variable costs
• Total Cost (TC) = TVC + TFC
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Average and Marginal Costs
• Average Fixed Cost (AFC): TFC/Output
• Average Variable Cost (AVC):
TVC/Output
• Average Total Cost (ATC or AC):
TC/Output
• Marginal Cost: TC/ Output or
TVC/ Output
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Figure 9-1
Typical total cost curves
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Figure 9-2
Average and marginal cost curves
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Things to Notice
• AFC always decreases
• MC may decrease at first but it
eventually must increase
• AVC and ATC are typically U-shaped
• MC=AVC at minimum point of AVC
• MC = ATC at minimum point of ATC
• ATC approaches AVC from above
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Figure 9-3
Cost curves for a diminishing marginal returns
production function
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Figure 9-4
Cost curves when marginal product
is constant
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Table 9-2
Illustration of Cost Concepts Applied to a
Stocking Rate Problem
Number Output MPP
of Steers Cwt Beef
0
0 ***
10
72 7.2
20
148 7.6
30
225 7.7
40
295 7.0
50
360 6.5
60
420 6.0
70
475 5.5
80
525 5.0
90
570 4.5
100
610 4.0
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TFC
($)
5,000
5,000
5,000
5,000
5,000
5,000
5,000
5,000
5,000
5,000
5,000
TVC
($)
0
4,950
9,900
14,850
19,800
24,750
29,700
34,650
39,600
44,550
49,500
TC
AFC
($)
($)
5,000 ***
9,950 69.44
14,900 33.78
19,850 22.22
24,800 16.95
29,750 13.89
34,700 11.90
39,650 10.53
44,600
9.52
49,550
8.77
54,500
8.20
AVC ATC
MC
MR
($)
($)
($)
($)
***
***
***
***
68.75 138.19 68.75 87.50
66.89 100.68 65.13 87.50
66.00 88.22 64.29 87.50
67.12 84.07 70.71 87.50
68.75 82.64 76.15 87.50
70.71 82.62 82.50 87.50
72.95 83.47 90.00 87.50
75.43 84.95 99.00 87.50
78.16 86.93 110.00 87.50
81.15 89.34 123.75 87.50
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Graph of ATC, AVC, MC and AFC
from Stocker Problem
Stocking Rate Problem
160.00
140.00
120.00
100.00
80.00
60.00
40.00
20.00
0.00
ATC
MC
AVC
AFC
0
100
200
300
400
500
600
700
cw t beef
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Application of Cost Concepts
Cost concepts can be used in both
short and long-run decision making.
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Production Rules for the Short Run
• If Price > ATC, produce and make a
profit.
• If ATC>Price>AVC produce and
minimize losses.
• If AVC> Price, do not produce and limit
your loss to your fixed costs.
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Logic behind These Rules
Fixed costs must be paid whether you
produce or not in any given year. They
are therefore irrelevant to the production
decision. You look at variable costs. If
you can cover those, you should produce.
If you can’t, you don’t produce.
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Producing at a Loss Example
Fixed Costs are $10,000. At the point where
MR=MC, TVC are $8,000 and TR is $12,000.
$10,000
If I don’t produce, I will have a loss of _______
$6,000
If I do produce, I will have a loss of _________
I should produce to minimize losses.
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If Losses Exceed Fixed Costs
Fixed Costs are $10,000. At the point where
MR=MC, TVC are $15,000 and TR is $12,000.
$10,000
If I don’t produce, I will have a loss of _______
$13,000
If I do produce, I will have a loss of _________
.
I should not
produce
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Figure 9-5
Illustration of short-run production decisions
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Don’t Produce: Graphical View
ATC
AVC
loses more than
fixed cost
MR = Price
MC
Output
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Produce at a Loss: Graphical View
ATC
AVC
loses less than
fixed cost
MR = Price
MC
Output
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Produce at a Profit: Graphical View
ATC
per-unit profit
AVC
MR = Price
MC
Output
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Production Rules for the Long Run
• Price > ATC. Continue to produce at
the point where MR=MC.
• Price < ATC. Stop production and sell
fixed assets.
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Economies of Size
• What is the most profitable farm size?
• Can larger farms produce food and
fiber more cheaply?
• Are large farms more efficient?
• Will family farms disappear and be
replaced by corporate farms?
• Will farm numbers continue to fall?
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Figure 9-6
Farm size in the short run
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Measuring Economies of Size
Percent Change in Costs
Percent Change in Output Value
Ratio value
Type of costs
<1
=1
>1
Decreasing
Constant
Increasing
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Figure 9-7
Possible size-cost relations
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Causes of Economies of Size
•
•
•
•
•
•
Full utilization of existing resources
Technology
Use of specialized resources
Decreasing input prices
Higher output prices
Management
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Causes of Diseconomies of Size
•
•
•
•
Management
Labor supervision
Geographical dispersion
Special problems of large livestock
operations
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Figure 9-8
Two possible LRAC curves
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Summary
This chapter discussed the different
economic costs and their use in
managerial decision making. An
analysis of costs is important for
understanding and improving the
profitability of a business. An
understanding of costs is also
necessary for analyzing economies
of size.
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